The best Canadian high yield stocks

As the Bank of Canada continues to hold rates steady, income seeking investors continue to seek fixed income alternatives, says Morningstar CPMS' Ian Tam

Ruth Saldanha 31 May, 2019 | 5:00PM

 

 

Ian Tam: Welcome to Quant Concepts. I am Ian Tam. As the Bank of Canada continues to hold rate steady, income seeking investors are likely continuing to look for alternatives to fixed income to provide a steady yield in their investment portfolio. This week I'll use Morningstar CPMS to look for higher yielding stocks trading in Canada, while keeping a close eye on how sustainable these divided yields are.

Using Morningstar CPMS, I'm going to consider all the companies that the CPMS system covers in Canada, which is about 694 stocks today. I'm going to take those 694 stocks and sort them based on fairly specific criteria aligned on my screen here.

So, the first two criteria are basically dividend yield, and there is a couple of ways to look at yield. You can look at yield based on trailing dividends, so what the company has already paid in the last four quarters. You can also look at yield on expected dividends. So, these are dividends that the company has announced that they're going to pay but have not yet paid yet. So, in my model today, I'm considering both of those yields, and together they are worth about half of my model. So, companies with higher yields are going to be ranked higher in my list of stocks out of those 694 names.

I'm also going to look at how stable the company's earnings are. So, in order for company to pay dividends, of course, they have to bring in profits or earnings and here we're looking for companies that have fairly consistent earnings per share over time. In fact, I'm looking over the last 10 years and I'm measuring that based on standard deviation of earnings. So, a company with very volatile earnings will be ranked little lower on my list and a company with very steady earnings over the last 10 years will be ranked higher on my list.

In a very similar way, I'm also going to look at how volatile the stock price movement is. And what I'll do is I'll look at the last 180 days of movement in the stock. And, of course, I want companies that are not moving too rapidly or too volatile and companies that are less volatile, again, in terms of their price movement will be ranked higher up in my list.

Now, when you're paying a dividend, companies have to be or investors rather have to be very cognizant of how much dividends are being paid out. So, a company with a high yield may look great. However, if that yield is not sustainable, i.e., the company cuts dividends in the future, that may not be so great for your investment portfolio.

So, one way to account for that is to look at the payout ratio on a company's dividends. So, payout ratio basically compares the dividend that's paid against either their earnings or their cash flows. And of course, we want a nice sustainable dividend over time and we don't want the company paying out too much of their earnings or too much of their cash flows in the form of dividends.

There's, again, a couple of ways to do this. When we look at sectors like energy, real estate and in some cases utilities, it's often worthwhile to look at the payout ratio in terms of those types of companies' cash flows; whereas all other sectors, a more traditional way to look at it is, looking at the payout against the company's earnings. So, in my model today (I am also) looking at both; in order for me to consider buying a stock, I will ensure that the company's payout ratio on earnings is less than 80% and the company's payout ratio on cash flows is less than 60%.

Additionally, to make sure these companies are relatively liquid, in Canada, I've excluded companies with a market cap that's lower than about $112 million; that represents roughly the bottom-third of market cap in our database. So, that's my model today. And of course, I'm going to use Morningstar CPMS to back-test this and show you how if I had picked these stocks in this manner over the last 10, 15 years or so, how that would have looked and how my results would look. So, I would run that back-test for you.

So, just like a traditional back-test what you've seen in a number of weeks in the past, what we're doing is we're starting with some amount of cash. In this case, we're starting with $1 million just prior to the tech bubble, so, around 1999. Using the $1 million, I would have purchased 15 stocks with no more than four stocks per sector. At the end of each subsequent month, I'll look at the portfolio and I see if any of those stocks dropped in rank. So, if they drop a little at the top half of my universe, I would sell the stock, or if we find that the company is paying out too much of their earnings or cash flows and dividends, I would sell the stock as well. Whenever I sell the stock, I would replace it with the next highest ranking stock, in this case, never owning more than four stocks per sector.

Now, because I'm considering the entire CPMS universe, which again today consists of about 694 companies, some of those companies might be less liquid. Meaning, it might be harder to get in and out of those positions. So, to ensure that I am factoring that in, in this analysis or this back-test, I have baked in a 1% liquidity cost. And what that means is for every time I sell a stock, I'm selling it for 1% lower than the market value on that day and whenever I buy a stock, I'm buying it for 1% higher. So, this is just a way for me to buffer my back-test results to ensure that I'm not overinflating what's happening in this case in the last 19 years or so.

So, you can see in terms of the pattern of the return here on the screen, it’s a fairly steady return, as you would imagine it would be for a dividend or a yield-focused portfolio. That's really the characteristic that we're looking for when we're building a dividend portfolio.

Okay. So, taking a look at the results here. The model returned about a 10.7% annualized rate of return, which compared against the S&P/TSX Composite is better by about 3.5%; again, considering that 1% liquidity cost over time.


  - source: Morningstar CPMS

The turnover on this model is very low; meaning, very likely we started with a set of 15 stocks and we pretty much held those stocks fairly consistently over the last 19 years. The Sharpe ratio which is a measure of risk-adjusted return, is about 1, which is fairly high when compared to the TSX composite, which has a Sharpe ratio of 0.8.

More importantly, or in another way to frame it, in all the quarters where the TSX was down over the last 19 years, we beat the TSX about 71% of the time, which speaks to the defensive nature of the portfolio. So, the stocks that qualify for purchase into this model today are listed in the table attached to the transcript for this video. Today's highest ranking stock is a firm, Capital Mortgage, which pays a yield of 6.9%. The company's dividends account for about 58% of its cash flow before changes in working capital. Firm Capital Mortgage is a Canadian non-bank lender, providing residential and commercial real estate financing.

About Author

Ruth Saldanha  Ruth Saldanha is Senior Editor at Morningstar.ca